Tuesday, 18 December 2012

The New Classical Revolution: Technical or Ideological?

Paul Krugman: “The state of macro is, in fact, rotten, and will remain so until the cult that has taken over half the field is somehow dislodged” The cult here is freshwater macro, which descends from the New Classical revolution. In responseSteve Williamson: “At the time, this revolution was widely-misperceived as a fundamentally conservative movement. It was actually a nerd revolution.” “What these people had on their side were mathematics, econometrics, and most of all the power of economic theory. There was nothing weird about what these nerds were doing - they were simply applying received theory to problems in macroeconomics. Why could that be thought of as offensive?”The New Classical revolution was clearly anti-Keynesian, in the sense of Keynesian theory of the 1960s/70s, but was that simply because Keynesian theory was the dominant paradigm? As Williamson says, these guys were outsiders, and they wanted to revolutionise the discipline, which meant attacking the dominant theoretical framework of the time, which was Keynesian IS/LM.[1]I have no particular expertise here: when this was all happening I viewed it from afar and with a lag, although perhaps that is also an advantage. But for what it is worth, I think there is some truth in what Stephen Williamson (SW) says. I certainly think that New Classical economists revolutionised macroeconomic theory, and that the theory is much better for it. Paul Krugman (PK) and I have disagreed on this point before. It was New Classical economists who recognised the importance of Muth’s rational expectations idea, and it is hard to imagine making sense of what the Fed has done this year without it.But this is not where the real disagreement between PK and SW lies. The New Classical revolution became the New Neoclassical Synthesis, with New Keynesian theory essentially taking the ideas of the revolutionaries and adapting Keynesian theory to incorporate them. Once again, I believe this was a progressive change. While there is plenty wrong with New Keynesian theory, and the microfoundations project on which it is based, I would much rather start from there than with the theory I was taught in the 1970s. As SW says “Most of us now speak the same language, and communication is good.” What New Keynesian theory does is allow central banks to apply New Classical ideas in a way that is relevant to the task they have to perform, which is inflation control through demand management. I think the difficulty that PK and I share is with those who in effect rejected or ignored the New Neoclassical Synthesis. I can think of no reason why the New Classical economist as ‘revolutionary nerd’ should do this, which suggests that SW’s characterisation is only half true. Everyone can have their opinion about particular ideas or developments, but it is not normal to largely ignore what one half of the profession is doing. Yet that seems to be what has happened in significant parts of academia.SW likes to dismiss PK as being out of touch with current macro research. Lets look at the evidence. PK was very much at the forefront of analysing the Zero Lower Bound problem, before that problem hit most of the world. While many point to Mike Woodford’s Jackson Hole paper as being the intellectual inspiration behind recent changes at the Fed, the technical analysis can be found in Eggertsson and Woodford, 2003. That paper’s introduction first mentions Keynes, and then Krugman’s 1998 paper on Japan. Subsequently we have Eggertsson and Krugman (2010), which is part of a flourishing research programme that adds ‘financial frictions’ into the New Keynesian model. You would not think of suggesting that PK is out of touch unless you are in effect dismissing or marginalising this whole line of research.[2] I would not describe the state of macro as rotten, because that appears to dismiss what most mainstream macroeconomists are doing. I would however describe it as suffering from two unhelpful biases. The first is methodological: too much of an obsession with microfoundation purity, and too little interest in evidence. The second is ideological: a legacy of the New Classical revolution that refuses to acknowledge the centrality of Keynesian insights to macroeconomics. These biases are a serious problem, partly because they can distort research effort, but also because they encourage policy makers to make major mistakes.[3][1] The clash between Monetarism and Keynesianism was mostly a clash about policy: Friedman used the Keynesian theoretical framework, and indeed contributed greatly to it. [2] It may be legitimate to suggest someone is out of touch with macro theory if they make statements that are just inconsistent with mainstream theory, without acknowledging this to be the case. The example that most obviously comes to mind is statements like these, about the impact of fiscal policy. [3] In the case of the UK, a charitable explanation for the Conservative opposition to countercyclical fiscal policy and their embrace of austerity was that they believed conventional monetary policy could always stabilise the economy. If they had taken on board PK’s analysis of Japan, or Eggertsson and Woodford, they would not have made that mistake.

Actually, I think we get this about right. If the tools are there to go deeper, and you can do it without losing clarity or tractability, you should do it. How much you do of course depends on the nature of the problem. For example, its not useful to have a theory of asset pricing that starts by defining preferences over assets. I think most people accept that. You can go too far with it though. Lucas regognizes that here:

http://www.economicdynamics.org/News271.htm#interview

"too little interest in evidence"

I don't know where you get that idea. I see plenty of good empirical work done by Keynesians and non-Keynesians. Note that the revolution itself was in part an empirical revolution.

"refuses to acknowledge the centrality of Keynesian insights to macroeconomics"

Is Keynes central to macroeconomics? Should he be? I don't know. As scientists, we don't just accept things - Keynes for example - as truth. We keep asking questions. That's what I do here for example:

There are people who take this stuff seriously, so I feel responsible to learn what it is about. I'm not dismissive, by any means. Of course, if I thought this was the most productive avenue for research, I would be doing it. Other people should feel free to do it, but I think there are higher returns elsewhere.

You would not think of suggesting that PK is out of touch unless you are in effect dismissing or marginalising this whole line of research.

This just does not follow logically. Of course, PK can do a NK model. The point that Steve is making is that PK appears to be completely ignorant of the world macroeconomists have done on financial frictions since the early RBC models. Yes, he is completely out of touch. And no, this is no way marginalizes the NK research program.

Forgive me, but could you expand on this please:"It was New Classical economists who recognised the importance of Muth’s rational expectations idea, and it is hard to imagine making sense of what the Fed has done this year without it."

In particular, "hard to imagine making sense of what the Fed has done"

Hm, so what is the new classical / New Keynesian answer to the outcome of the Capital Debates? Hand-wawing, I guess.

So the Cambridge UK school of economics have revolutionized macro and shown that marginalism is logically inconsistent even at the micro level. Enter the New Classicals with REH, etc. and say: the problem with economics is that there is too little marginalism micro underpinning the bastard-Keynesian macro. We should, consequently, work harder to base our understanding of macro on the marginalism micro, no matter the logical problems of marginalism and no matter empirical evidence.

Great. So the last 20 or so years in macroeconomic research have been spent trying to base the somewhat functioning bastard-keynesianism on the empiricilally unproven and logically inconsistent marginalist micro, bacause, you know, you can use complicated maths in DSGE modelling. I'd say 'rotten' is too charitable a word givien the consequences of this theory in the realm of practical policy making.

Hasn't the Conservative Party always been in favour of reducing government expenditure and the size of the State, the Labour Party more or less the opposite? The policies are consistent, it's the intellectual justification that changes with the times. The evidence is selected to suit.

The majority of the population will always follow what PK's Very Serious People suggest, deferring to a perceived higher authority and insider knowledge (Blair's justification for the invasion of Iraq being a classic)unless it is manifestly going horribly wrong. in that case this recession has not been severe enough to convince the average voter to risk rejecting austerity and Very Serious Conservatives in favour of a Keynesian boost from a Not Very Serious Labour Party.

After Gordon Brown's failings (if only because it was his hand on the wheel when the ship hit the rocks) and the successful interaction of debt paranoia and the historic characterisation of Labour as spendthrifts, Labour are unable to adopt a sufficiently serious posture to convince the electorate that there is a practical alternative.

It strikes me as odd that you need to reply whether Krugman is or not at the forefront of research in macro. Note that not being trendy and fashionable, which is the actual meaning of Williamson's "being out of touch" critique, is uterly irrelevant. What it is expected of science is not fashion, but relevance following logic and evidence. In fact, I would argue that Krugman is penalized by using the fashionable DSGE (but New Keynesian) models, which are not as good as old fashioned Keynesian models without intertemporal maximization. Note that Godley type models (developed there in Cambridge) have done much better at explaining and predicting the crisis.

Robert Lucas and the intellectual collapse of freshwater economics-Professor Lars Pålsson Syll Malmö University

https://larspsyll.wordpress.com/2012/12/31/robert-lucas-and-the-intellectual-collapse-of-freshwater-economics/#comment-312131 December, 2012 In a recent lecture on the US recession, Robert Lucas gave an outline of what the new classical school of macroeconomics today thinks on the latest downturns in the US economy and its future prospects.

Lucas starts by showing that real US GDP has grown at an average yearly rate of 3 per cent since 1870, with one big dip during the Depression of the 1930s and a big – but smaller – dip in the recent recession.

After stating his view that the US recession that started in 2008 was basically caused by a run for liquidity, Lucas then goes on to discuss the prospect of recovery from where the US economy is today, maintaining that past experience would suggest an “automatic” recovery, if the free market system is left to repair itself to equilibrium unimpeded by social welfare activities of the government.

As could be expected there is no room for any Keynesian type considerations on eventual shortages of aggregate demand discouraging the recovery of the economy. No, as usual in the new classical macroeconomic school’s explanations and prescriptions, the blame game points to the government and its lack of supply side policies.

Lucas is convinced that what might arrest the recovery are higher taxes on the rich, greater government involvement in the medical sector and tougher regulations of the financial sector. But – if left to run its course unimpeded by European type welfare state activities -the free market will fix it all.

In a rather cavalier manner – without a hint of argument or presentation of empirical facts – Lucas dismisses even the possibility of a shortfall of demand. For someone who already 30 years ago proclaimed Keynesianism dead – “people don’t take Keynesian theorizing seriously anymore; the audience starts to whisper and giggle to one another” – this is of course only what could be expected. Demand considerations are simply ruled out on whimsical theoretical-ideological grounds, much like we have seen other neo-liberal economists do over and over again in their attempts to explain away the fact that the latest economic crises shows how the markets have failed to deliver. If there is a problem with the economy, the true cause has to be government.

Trying to explain business cycles in terms of rational expectations has failed blatantly. Maybe it would be asking to much of freshwater economists like Lucas to concede that, but it’s still a fact that ought to be embarrassing. My rational expectation is that 30 years from now, no one will know who Robert Lucas was. John Maynard Keynes, on the other hand, will still be known as one of the masters of economics.

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